2009 (10) TMI 627 - HC - Income Tax

Disallowance of claim of provision of warranty - warranty is based on a scientific method and that it was based on past practice and experience - warranty expense, if properly ascertained and discounted on accrual basis can be an item of deduction under section 37 - It would depend on the nature of the business, the nature of sales, the nature of the product manufactured and sold and the scientific method of accounting adopted by the assessee. It would also depend upon the historical trend and upon the number of articles produced Held that - historical trend indicates that a large number of sophisticated goods were being manufactured in the past and the facts show that defects existed in some of the items manufactured and sold, then provision made for warranty in respect of such sophisticated goods would be entitled to deduction from the gross receipts under section 37, in the light of the decision of the Supreme Court in the case of Rotork Controls India P. Ltd.(2009 - TMI - 33420 - SUPREME COURT OF INDIA), tax case appeal has to be allowed by answering all questions of law in favour of the assessee and against the Revenue.

Issues:
1. Disallowance of provision for warranty during the assessment year 2004-05.
2. Allowability of provision for warranty based on scientific method and past practice.
3. Interpretation of Madras High Court decision on the claim for provision for warranty.

Analysis:

Issue 1: Disallowance of provision for warranty during the assessment year 2004-05
The appellant, engaged in the business of manufacturing lifts, had made a provision for warranty based on a scientific method of ascertainment of possible liability arising from warranty obligations. Despite following a consistent method of accounting, the Assessing Officer disallowed the provision for warranty claim during the assessment year 2004-05, citing it as an unascertained liability. The Commissioner of Income-tax (Appeals) initially decided in favor of the assessee, but the Assessing Officer continued to disallow the claim. The Tribunal, referring to a decision of the Madras High Court, upheld the disallowance. However, the Supreme Court in Rotork Controls India P. Ltd. v. CIT reversed the decision, emphasizing that warranty provisions can be recognized as a liability if certain conditions are met, such as a present obligation from past events and a reliable estimate of the obligation amount. The court held that a provision for warranty, if properly ascertained, can be deductible under section 37 of the Income-tax Act, 1961.

Issue 2: Allowability of provision for warranty based on scientific method and past practice
The appellant had a contractual obligation to rectify defects in lifts under warranty clauses with customers. The provision for warranty was made after a scientific ascertainment of the possible liability, considering past data and the number of lifts sold. The Division Bench of the Madras High Court, in a previous case, followed the Supreme Court's decision and allowed the appeal, emphasizing that if historical trends and the nature of the business support the provision for warranty, it should be deductible under section 37. The court highlighted that a provision is recognized when there is a present obligation from a past event, a probable outflow of resources, and a reliable estimate of the obligation amount.

Issue 3: Interpretation of Madras High Court decision on the claim for provision for warranty
The Tribunal had relied on a decision of the Madras High Court to disallow the provision for warranty, stating that it cannot be allowed without the incurrence of liability under the warranty clause. However, the Supreme Court's judgment clarified that warranty provisions can be recognized as liabilities if certain conditions are met, such as a present obligation from past events and a reliable estimate of the obligation amount. The court emphasized that the nature of the business, historical trends, and the scientific method of accounting adopted by the assessee should be considered when determining the allowability of a provision for warranty.

In conclusion, the High Court allowed the tax case appeal, answering all three questions of law in favor of the assessee and against the Revenue, based on the Supreme Court's decision in Rotork Controls India P. Ltd. v. CIT, which established the criteria for the deductibility of provision for warranty under section 37 of the Income-tax Act, 1961.

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